How Does Liquidity Affect Government Bond Yields?

61 Pages Posted: 26 Jan 2009 Last revised: 29 Jan 2009

See all articles by Carlo A. Favero

Carlo A. Favero

Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)

Marco Pagano

University of Naples Federico II - Department of Economics and Statistics; Centre for Studies in Economics and Finance (CSEF); Einaudi Institute for Economics and Finance (EIEF); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Ernst-Ludwig von Thadden

Universitaet Mannheim; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 3 versions of this paper

Date Written: January 18, 2008

Abstract

The paper explores the determinants of yield differentials between sovereign bonds, using Euro area data. There is a common trend in yield differentials, which is correlated with a measure of aggregate risk. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We propose a simple model with endogenous liquidity demand, where a bond's liquidity premium depends both on its transaction cost and on investment opportunities. The model predicts that yield differentials should increase in both liquidity and risk, with an interaction term of the opposite sign. Testing these predictions on daily data, we find that the aggregate risk factor is consistently priced, liquidity differentials are priced for a subset of countries, and their interaction with the risk factor is in line with the model's prediction and crucial to detect their effect.

Keywords: bond markets, liquidity, risk

JEL Classification: E43, G12

Suggested Citation

Favero, Carlo A. and Pagano, Marco and von Thadden, Ernst-Ludwig, How Does Liquidity Affect Government Bond Yields? (January 18, 2008). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1332967

Carlo A. Favero

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

HOME PAGE: http://www.igier.unibocconi.it\favero

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Marco Pagano

University of Naples Federico II - Department of Economics and Statistics ( email )

Via Cintia - Monte S. Angelo
Napoli, 80126
Italy
+39 081 675306 (Phone)
+39 081 7663540 (Fax)

Centre for Studies in Economics and Finance (CSEF) ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

Einaudi Institute for Economics and Finance (EIEF)

Via Sallustiana, 62
Rome, 00187
Italy

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http:/www.ecgi.org

Ernst-Ludwig Von Thadden (Contact Author)

Universitaet Mannheim ( email )

Department of Economics
Mannheim, 68131
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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